Chapter Thirty-Two

1
Chapter Thirty-Two

• Externalities

2
Externalities

• An externality is a cost or a benefit imposed
  upon someone by actions taken by others. The
  cost or benefit is thus generated externally to
  that somebody.
• An externally imposed benefit is a positive
  externality.
• An externally imposed cost is a negative
  externality.

3
Examples of Negative Externalities

• Air pollution.
• Water pollution.
• Loud parties next door.
• Traffic congestion.
• Second-hand cigarette smoke.
• Increased insurance premiums due to alcohol or
  tobacco consumption.

4
Examples of Positive Externalities

• A well-maintained property next door that raises
  the market value of your property.
• A pleasant cologne or scent worn by the person
  seated next to you.
• Improved driving habits that reduce accident
  risks.
• A scientific advance.

5
Externalities and Efficiency

• Crucially, an externality impacts a third party
  i.e. somebody who is not a participant in the
  activity that produces the external cost or
  benefit.

6
Externalities and Efficiency

• Externalities cause Pareto inefficiency
  typically
• too much scarce resource is allocated to an
  activity which causes a negative externality
• too little resource is allocated to an activity
  which causes a positive externality.

7
Externalities and Property Rights

• An externality will viewed as a purely public
  commodity.
• A commodity is purely public if
• it is consumed by everyone (nonexcludability),
  and
• everybody consumes the entire amount of the
  commodity (nonrivalry in consumption).
• E.g. a broadcast television program.

8
Inefficiency Negative Externalities

• Consider two agents, A and B, and two
  commodities, money and smoke.
• Both smoke and money are goods for Agent A.
• Money is a good and smoke is a bad for Agent B.
• Smoke is a purely public commodity.

9
Inefficiency Negative Externalities

• Agent A is endowed with yA.
• Agent B is endowed with yB.
• Smoke intensity is measured on a scale from 0 (no
  smoke) to 1 (maximum concentration).

10
Inefficiency Negative Externalities
Smoke
Money and smoke areboth goods for Agent A.
1
0
mA
yA
OA
11
Inefficiency Negative Externalities
Smoke
Money and smoke areboth goods for Agent A.
1
Better
0
mA
yA
OA
12
Inefficiency Negative Externalities
Smoke
Money is a good and smoke is a bad for Agent B.
1
Better
0
mB
yB
OB
13
Inefficiency Negative Externalities
Money is a good and smoke is a bad for Agent B.
Smoke
1
0
mB
yB
OB
14
Inefficiency Negative Externalities

• What are the efficient allocations of smoke and
  money?

15
Inefficiency Negative Externalities
Smoke
Smoke
1
1
0
0
mA
yA
mB
yB
OA
OB
16
Inefficiency Negative Externalities
Smoke
Smoke
1
1
0
0
yA
yB
OA
OB
mA
mB
17
Inefficiency Negative Externalities
Smoke
Smoke
1
1
0
0
yA
yB
OA
OB
mA
mB
18
Inefficiency Negative Externalities
Smoke
Smoke
1
1
0
0
yA
yB
OA
OB
mA
mB
19
Inefficiency Negative Externalities
Smoke
Smoke
1
1
Efficient allocations
0
0
yA
yB
OA
OB
mA
mB
20
Inefficiency Negative Externalities

• Suppose there is no means by which money can be
  exchanged for changes in smoke level.
• What then is Agent As most preferred allocation?
• Is this allocation efficient?

21
Inefficiency Negative Externalities
Smoke
Smoke
1
1
Efficient allocations
0
0
yA
yB
OA
OB
mA
mB
22
Inefficiency Negative Externalities
Smoke
Smoke
As choices
1
1
Efficient allocations
0
0
yA
yB
OA
OB
mA
mB
23
Inefficiency Negative Externalities
As mostpreferred choiceis inefficient
Smoke
Smoke
1
1
Efficient allocations
0
0
yA
yB
OA
OB
mA
mB
24
Inefficiency Negative Externalities

• Continue to suppose there is no means by which
  money can be exchanged for changes in smoke
  level.
• What is Agent Bs most preferred allocation?
• Is this allocation efficient?

25
Inefficiency Negative Externalities
Smoke
Smoke
Bs choices
1
1
Efficient allocations
0
0
yA
yB
OA
OB
mA
mB
26
Inefficiency Negative Externalities
Bs mostpreferred choice
Smoke
Smoke
1
1
Efficient allocations
0
0
yA
yB
OA
OB
mA
mB
27
Inefficiency Negative Externalities
Bs mostpreferred choiceis inefficient
Smoke
Smoke
1
1
Efficient allocations
0
0
yA
yB
OA
OB
mA
mB
28
Inefficiency Negative Externalities

• So if A and B cannot trade money for changes in
  smoke intensity, then the outcome is inefficient.
• Either there is too much smoke (As most
  preferred choice) or there is too little smoke
  (Bs choice).

29
Externalities and Property Rights

• Ronald Coases insight is that most externality
  problems are due to an inadequate specification
  of property rights and, consequently, an absence
  of markets in which trade can be used to
  internalize external costs or benefits.

30
Externalities and Property Rights

• Causing a producer of an externality to bear the
  full external cost or to enjoy the full external
  benefit is called internalizing the externality.

31
Externalities and Property Rights

• Neither Agent A nor Agent B owns the air in their
  room.
• What happens if this property right is created
  and is assigned to one of them?

32
Externalities and Property Rights

• Suppose Agent B is assigned ownership of the air
  in the room.
• Agent B can now sell rights to smoke.
• Will there be any smoking?
• If so, how much smoking and what will be the
  price for this amount of smoke?

33
Externalities and Property Rights

• Let p(sA) be the price paid by Agent A to Agent B
  in order to create a smoke intensity of sA.

34
Externalities and Property Rights
Smoke
Smoke
1
1
0
0
yA
yB
OA
OB
mA
mB
35
Externalities and Property Rights
Smoke
Smoke
1
1
0
0
yA
yB
OA
OB
mA
mB
36
Externalities and Property Rights
Smoke
Smoke
p(sA)
1
1
sA
0
0
yA
yB
OA
OB
mA
mB
37
Externalities and Property Rights
Smoke
Smoke
p(sA)
1
1
Both agents gain and there is a positive amount
of smoking.
sA
0
0
yA
yB
OA
OB
mA
mB
38
Externalities and Property Rights
Smoke
Smoke
p(sA)
Establishing a market for trading rights to smoke
causes an efficient allocation to be achieved.
1
1
sA
0
0
yA
yB
OA
OB
mA
mB
39
Externalities and Property Rights

• Suppose instead that Agent A is assigned the
  ownership of the air in the room.
• Agent B can now pay Agent A to reduce the smoke
  intensity.
• How much smoking will there be?
• How much money will Agent B pay to Agent A?

40
Externalities and Property Rights
Smoke
Smoke
1
1
0
0
yA
yB
OA
OB
mA
mB
41
Externalities and Property Rights
Smoke
Smoke
1
1
0
0
yA
yB
OA
OB
mA
mB
42
Externalities and Property Rights
Smoke
Smoke
p(sB)
1
1
sB
0
0
yA
yB
OA
OB
mA
mB
43
Externalities and Property Rights
Smoke
Smoke
p(sB)
1
1
Both agents gain and there is a reduced amount
of smoking.
sB
0
0
yA
yB
OA
OB
mA
mB
44
Externalities and Property Rights
Smoke
Smoke
p(sB)
Establishing a market for trading rights to
reducesmoke causes an efficient allocation
to be achieved.
1
1
sB
0
0
yA
yB
OA
OB
mA
mB
45
Externalities and Property Rights

• Notice that the
• agent given the property right (asset) is better
  off than at her own most preferred allocation in
  the absence of the property right.
• amount of smoking that occurs in equilibrium
  depends upon which agent is assigned the property
  right.

46
Externalities and Property Rights
Smoke
Smoke
p(sB)
p(sA)
1
1
sB
sA ¹ sB
sA
0
0
yA
yB
OA
OB
mA
mB
47
Externalities and Property Rights

• Is there a case in which the same amount of
  smoking occurs in equilibrium no matter which
  agent is assigned ownership of the air in the
  room?

48
Externalities and Property Rights
Smoke
Smoke
p(sB)
p(sA)
1
1
sA sB
0
0
yA
yB
OA
OB
mA
mB
49
Externalities and Property Rights
Smoke
Smoke
p(sB)
p(sA)
1
1
sA sB
0
0
yA
yB
OA
OB
For both agents, the MRS is constant asmoney
changes, for given smoke intensity.
50
Externalities and Property Rights
Smoke
Smoke
p(sB)
p(sA)
1
1
sA sB
0
0
yA
yB
OA
OB
So, for both agents, preferences must
bequasilinear in money U(m,s) m f(s).
51
Coases Theorem

• Coases Theorem is If all agents preferences
  are quasilinear in money, then the efficient
  level of the externality generating commodity is
  produced no matter which agent is assigned the
  property right.

52
Production Externalities

• A steel mill produces jointly steel and
  pollution.
• The pollution adversely affects a nearby fishery.
• Both firms are price-takers.
• pS is the market price of steel.
• pF is the market price of fish.

53
Production Externalities

• cS(s,x) is the steel firms cost of producing s
  units of steel jointly with x units of pollution.
• If the steel firm does not face any of the
  external costs of its pollution production then
  its profit function is and the firms problem
  is to

54
Production Externalities
The first-order profit-maximizationconditions are
55
Production Externalities
The first-order profit-maximizationconditions are
and
56
Production Externalities
states that the steel firm
should produce the output level of steel for
which price marginal production cost.
57
Production Externalities
states that the steel firm
should produce the output level of steel for
which price marginal production cost.
is the rate at which the firms
internal production cost goes down as
the pollution level rises
58
Production Externalities
states that the steel firm
should produce the output level of steel for
which price marginal production cost.
is the rate at which the firms
internal production cost goes down as
the pollution level rises, so
is the marginal cost to the firm of pollution
reduction.
59
Production Externalities
is the marginal cost to the firm of pollution
reduction.
What is the marginal benefit to the steel firm
from reducing pollution?
60
Production Externalities
is the marginal cost to the firm of pollution
reduction.
What is the marginal benefit to the steel firm
from reducing pollution? Zero, since the firm
does not face its external cost. Hence the steel
firm chooses the pollution level for which
61
Production Externalities
E.g. suppose cS(s,x) s2 (x - 4)2 andpS 12.
Then
and the first-order profit-maximizationconditions
are
and
62
Production Externalities
determines the profit-max.
output level of steel s 6.
63
Production Externalities
determines the profit-max.
output level of steel s 6.
is the marginal cost to the firm
from pollution reduction. Since it gets no
benefit from this it sets x 4.
64
Production Externalities
determines the profit-max.
output level of steel s 6.
is the marginal cost to the firm
from pollution reduction. Since it gets no
benefit from this it sets x 4.
The steel firms maximum profit level isthus
65
Production Externalities

• The cost to the fishery of catching f units of
  fish when the steel mill emits x units of
  pollution is cF(f,x). Given f, cF(f,x) increases
  with x i.e. the steel firm inflicts a negative
  externality on the fishery.

66
Production Externalities

• The cost to the fishery of catching f units of
  fish when the steel mill emits x units of
  pollution is cF(f,x). Given f, cF(f,x) increases
  with x i.e. the steel firm inflicts a negative
  externality on the fishery.
• The fisherys profit function isso the
  fisherys problem is to

67
Production Externalities
The first-order profit-maximizationcondition is
68
Production Externalities
The first-order profit-maximizationcondition is
69
Production Externalities
The first-order profit-maximizationcondition is
Higher pollution raises the fisherysmarginal
production cost and lowers bothits output level
and its profit. This is the external cost of the
pollution.
70
Production Externalities
E.g. suppose cF(fx) f2 xf and pF 10.The
external cost inflicted on the fishery by the
steel firm is xf. Since the fishery has no
control over x it must take the steel firms
choice of x as a given. The fisherys profit
function is thus
71
Production Externalities
Given x, the first-order profit-maximizationcondi
tion is
72
Production Externalities
Given x, the first-order profit-maximizationcondi
tion is
So, given a pollution level x inflicted uponit,
the fisherys profit-maximizing outputlevel is
73
Production Externalities
Given x, the first-order profit-maximizationcondi
tion is
So, given a pollution level x inflicted uponit,
the fisherys profit-maximizing outputlevel is
Notice that the fishery produces less, andearns
less profit, as the steel firmspollution level
increases.
74
Production Externalities
The steel firm, ignoring its
external cost inflicted upon the
fishery,chooses x 4, so the
fisherysprofit-maximizing output level given
thesteel firms choice of pollution level isf
3, giving the fishery a maximumprofit level of
Notice that the external cost is 12.
75
Production Externalities

• Are these choices by the two firms efficient?
• When the steel firm ignores the external costs of
  its choices, the sum of the two firms profits is
  36 9 45.
• Is 45 the largest possible total profit that can
  be achieved?

76
Merger and Internalization

• Suppose the two firms merge to become one. What
  is the highest profit this new firm can achieve?

77
Merger and Internalization

• Suppose the two firms merge to become one. What
  is the highest profit this new firm can
  achieve?
• What choices of s, f and x maximize the new
  firms profit?

78
Merger and Internalization
The first-order profit-maximizationconditions are
The solution is
79
Merger and Internalization
And the merged firms maximum profitlevel is
This exceeds 45, the sum of the non- merged
firms.
80
Merger and Internalization

• Merger has improved efficiency.
• On its own, the steel firm produced x 4 units
  of pollution.
• Within the merged firm, pollution production is
  only xm 2 units.
• So merger has caused both an improvement in
  efficiency and less pollution production. Why?

81
Merger and Internalization
The steel firms profit function is
so the marginal cost of producing x units of
pollution is
When it does not have to face the external costs
of its pollution, the steel firm increases
pollution until this marginal cost is zero hence
x 4.
82
Merger and Internalization
In the merged firm the profit function is
The marginal cost of pollution is thus
83
Merger and Internalization
In the merged firm the profit function is
The marginal cost of pollution is
84
Merger and Internalization
In the merged firm the profit function is
The marginal cost of pollution is
The merged firms marginal pollution cost is
larger because it faces the full cost of its own
pollution through increased costs of production
in the fishery, so less pollution is produced by
the merged firm.
85
Merger and Internalization

• But why is the merged firms pollution level of
  xm 2 efficient?

86
Merger and Internalization

• But why is the merged firms pollution level of
  xm 2 efficient?
• The external cost inflicted on the fishery is xf,
  so the marginal external pollution cost is

87
Merger and Internalization

• But why is the merged firms pollution level of
  xm 2 efficient?
• The external cost inflicted on the fishery is xf,
  so the marginal external pollution cost is
• The steel firms cost of reducing pollution is

88
Merger and Internalization

• But why is the merged firms pollution level of
  xm 2 efficient?
• The external cost inflicted on the fishery is xf,
  so the marginal external pollution cost is
• The steel firms cost of reducing pollution is
• Efficiency requires

89
Merger and Internalization

• Merger therefore internalizes an externality and
  induces economic efficiency.
• How else might internalization be caused so that
  efficiency can be achieved?

90
Coase and Production Externalities

• Coase argues that the externality exists because
  neither the steel firm nor the fishery owns the
  water being polluted.
• Suppose the property right to the water is
  created and assigned to one of the firms. Does
  this induce efficiency?

91
Coase and Production Externalities

• Suppose the fishery owns the water.
• Then it can sell pollution rights, in a
  competitive market, at px each.
• The fisherys profit function becomes

92
Coase and Production Externalities

• Suppose the fishery owns the water.
• Then it can sell pollution rights, in a
  competitive market, at px each.
• The fisherys profit function becomes
• Given pf and px, how many fish and how many
  rights does the fishery wish to produce? (Notice
  that x is now a choice variable for the fishery.)

93
Coase and Production Externalities
The profit-maximum conditions are
94
Coase and Production Externalities
The profit-maximum conditions are
and these give
(fish supply)
(pollution right supply)
95
Coase and Production Externalities

• The steel firm must buy one right for every unit
  of pollution it emits so its profit function
  becomes
• Given pf and px, how much steel does the steel
  firm want to produce and how many rights does it
  wish to buy?

96
Coase and Production Externalities
The profit-maximum conditions are
97
Coase and Production Externalities
The profit-maximum conditions are
(steel supply)
and these give
(pollution right demand)
98
Coase and Production Externalities
In a competitive market for pollution rights the
price px must adjust to clear the market so, at
equilibrium,
99
Coase and Production Externalities
In a competitive market for pollution rights the
price px must adjust to clear the market so, at
equilibrium,
The market-clearing price for pollution rights is
thus
100
Coase and Production Externalities
In a competitive market for pollution rights the
price px must adjust to clear the market so, at
equilibrium,
The market-clearing price for pollution rights is
thus
and the equilibrium quantity of rights traded is
101
Coase and Production Externalities
102
Coase and Production Externalities
So if ps 12 and pf 10 then
This is the efficient outcome.
103
Coase and Production Externalities

• Q Would it matter if the property right to the
  water had instead been assigned to the steel
  firm?
• A No. Profit is linear, and therefore
  quasi-linear, in money so Coases Theorem states
  that the same efficient allocation is achieved
  whichever of the firms was assigned the property
  right. (And the asset owner gets richer.)

104
The Tragedy of the Commons

• Consider a grazing area owned in common by all
  members of a village.
• Villagers graze cows on the common.
• When c cows are grazed, total milk production is
  f(c), where fgt0 and flt0.
• How should the villagers graze their cows so as
  to maximize their overall income?

105
The Tragedy of the Commons
Milk
f(c)
c
106
The Tragedy of the Commons

• Make the price of milk 1 and let the relative
  cost of grazing a cow be pc. Then the profit
  function for the entire village isand the
  villages problem is to

107
The Tragedy of the Commons
The income-maximizing number of cows to graze,
c, satisfies
i.e. the marginal income gain from the last cow
grazed must equal the marginal cost of grazing it.
108
The Tragedy of the Commons
pcc
Milk
f(c)
slope f(c)
slope pc
c
c
109
The Tragedy of the Commons
pcc
Milk
f(c)
slope f(c)
f(c)
Maximal income
slope pc
c
c
110
The Tragedy of the Commons

• For c c, the average gain per cow grazed
  isbecause f gt 0 and f lt 0.

111
The Tragedy of the Commons
pcc
Milk
f(c)
slope f(c)
f(c)
c
c
112
The Tragedy of the Commons

• For c c, the average gain per cow grazed
  isbecause f gt 0 and f lt 0. So the economic
  profit from introducing one more cow is positive.
• Since nobody owns the common, entry is not
  restricted.

113
The Tragedy of the Commons

• Entry continues until the economic profit of
  grazing another cow is zero that is, until

114
The Tragedy of the Commons
pcc
Milk
f(c)
slope f(c)
f(c)
c
c
115
The Tragedy of the Commons
pcc
Milk
f(c)
slope f(c)
f(c)
c
c
The commons are over-grazed, tragically.
116
The Tragedy of the Commons

• The reason for the tragedy is that when a
  villager adds one more cow his income rises (by
  f(c)/c - pc) but every other villagers income
  falls.
• The villager who adds the extra cow takes no
  account of the cost inflicted upon the rest of
  the village.

117
The Tragedy of the Commons

• Modern-day tragedies of the commons include
• over-fishing the high seas
• over-logging forests on public lands
• over-intensive use of public parks e.g.
  Yellowstone.
• urban traffic congestion.